Conclusions on Earnings Management

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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

1.

To Outline Reasons for Earnings Management

I recommend introducing students to the topic of earnings management by discussing

Healys seminal 1985 bonus plan paper. Healys evidence that bonus plans motivateearnings management helps students to take contracting theory seriously. It opens up awhole new set of considerations in accounting policy choice beyond the disclosure of usefulinformation to investors.While it is somewhat cynical, I sometimes ask the question whether management wouldadmit to the behaviour documented by Healy, and whether the auditor would assist oroppose the manager in this type of earnings management. For those interested in researchmethodology, Healys paper can be used to point out the desirability in accounting researchareas such as this of using empirical analysis of hard data, with good experimental designand statistical analysis, in order to more fully understand managements accounting policychoices.Having said this, it is important that the Healy results not be oversold, since Healy facedsubstantial methodological problems, particularly with respect to separating discretionary andnon-discretionary accruals. The text contains discussions of some of these problems, and theresults of some subsequent papers, in Section 11.3. The Jones (1991) methodology which,with some variants, is still the state of the art in this area is reviewed in Section 8.5.3. I do notspend much class time on these methodological issues, other than a brief review of theHolthausen, Larcker and Sloan (1995) paper. This paper, with better data and differentmethodology, supports Healys results for firms with above-cap earnings, even thoughHealys below-bogey results seem to disappear in their study.Since it now appears that meeting earnings expectations drove at least some of the financialreporting scandals of the early 2000s, such as WorldCom, I also suggest class discussion ofthe material in Section 11.4.2. This sets up the point that earnings management relates toreporting to investors as well as contracting.

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2.

To Appreciate the Good Side of Earnings Management

I begin by asking if the earnings management behaviour documented by Healy is good or

bad. I usually take the role of arguing it is good, from an efficient contracting perspective.This argument assumes, however, that the earnings management was anticipated by theprincipal when the bonus contract was being negotiated, so that it is allowed for in setting thebonus rate.While most people probably view earnings management with suspicion, I suggest 2 goodsides. One, as just mentioned, is to lower contracting costs in the face of rigid and incompletecontracts.A second, and more controversial, side is that earnings management can reveal insideinformation to investors. A provocative discussion question here is to ask if earningsmanagement can be thought of as an extension of the accrual process. That is, if accrualssmooth out lumpy cash flows to produce a more useful measure of quarterly and annualperformance, why cant earnings management be used to smooth out annual accrual-basedearnings to produce a more useful multi-year measure of persistent earning power? Such ameasure may help investors better predict future firm performance, which is a major goal offinancial reporting.To pursue the argument that earnings management as a vehicle to release inside informationcan be good, the case of General Electric Co. (Problem 9 of this chapter) works well to getthe point across. The steady increase in GEs reported earnings over the years is quiteimpressive. I point out the complexity of GE to the point where even financial analysts havedifficulty in understanding the whole company. As a result, it is very difficult to estimate GEspersistent earning power. I also point out that a simple announcement by GE of its persistentfuture earnings is blocked. Such an announcement lacks credibility since, for such acomplex company, the market has little ability to verify it. This sets up the role of goodearnings management as a credible way to reveal this information. An argument that GEdoes engage in earnings management for this purpose is supported by both the variety ofearnings management devices available to it and the steadily increasing pattern of itsearnings over time.

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It is interesting to note that GEs earnings management came under suspicion in the marketin the early 2000s, due to the severe apprehension of post-Enron investors about earningsmanagement in general. According to an article General Electric: Big game hunting in TheEconomist (March 14, 2002) investors may have interpreted GEs increased reportedearnings for 2001 as evidence of bad earnings management, since poor economic conditionsduring 2001 suggest that earnings should have declined. In addition, GE appointed a newCEO in late 2001. The Economist suggests that the market may have less trust in the newCEO than in Jack Welch, the highly regarded former CEO, simply because he is less of aknown quantity. As a result, the market may have felt that there is a higher likelihood that GEwill use its considerable potential for earnings management for bad purposes rather thangood.GEs response to these market concerns is worth noting. It started to release considerablymore information. Further discussion of how GE worked to overcome investor scepticism isgiven in Problem 21 of Chapter 12.Theoretical and empirical evidence in favour of good earnings management is given inSection 11.5.2, which I have marked as optional reading for those that wish to pursue goodearnings management in greater depth. Suffice it to say that there is considerable evidencein this regard.3.

To Appreciate the Bad Side of Earnings Management

Despite the above arguments, most people would likely regard earnings management withsuspicion, reinforced by revelation of serious abuses of earnings management by Enron andWorldCom and numerous other corporations in the early 2000s. Consequently, studentsshould not be left with the impression that it is necessarily good. A useful place to start isHannas 1999 article in CA Magazine, which is well worth assigning and discussing. Theimportant point to get across from this article is that management is tempted to provideexcessive unusual, non-recurring and extraordinary charges, to put future earnings in thebank. Furthermore, these future earnings are buried in operations. This makes it difficult forinvestors to diagnose the reasons for subsequent earnings increases. Nortel Networksreversals of its excess accruals (see Theory in Practice vignette11.1 in Section 11.6.1)provide a vivid example of Hannas argument. Also, the effect on future profits of puttingCopyright 2009 Pearson Education Canada

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earnings in the bank has been recognized by an article in The Economist (A world awashwith profits, Business is booming almost everywhere, February 18, 2005, pp. 62-63). Thisarticle states that one reason for the dramatic increase in firm profits during 2002-2004 is thatthey are an accounting fiction, which apparently means that they are a consequence ofearlier writeoffs.I find that to drive home these various considerations, an example of how earningsmanagement can go too far is instructive. An excellent case in point is the downfall ofChainsaw Al Dunlap at Sunbeam Corp. Jonathan Laings 1998 article in Forbes isreproduced in Question 10. Laing demonstrates that Sunbeams 1997 reported earningswere almost completely manufactured by means of discretionary accruals. The substantialfirst quarter, 1998, loss reported by Sunbeam supports Laings analysis, and the iron law ofaccrual reversal.I think that Laings analysis of the effects of the $17.2 million drop in Sunbeams prepaidexpenses for 1997 is backwardssee part a of Question 10. If I am not correct in this,presumably other instructors will let me know. However, even taking this error into accountdoes not substantially alter Laings conclusion that 1997 earnings were manufactured.4.

Do Managers Accept Securities Market Efficiency?

Evidence of good earnings management is consistent with managers beliefs that marketsare reasonably efficient. Why use earnings management to reveal inside information if themarket cannot interpret it? However, evidence of bad earnings management may or may notbe consistent with efficiency.On the one hand, managers may feel that they can fool the market by managing theirearnings, which seems to have been the case with Sunbeam management. Emphasizing proforma earnings (Section 7.4.2) is another tactic that seems inconsistent with acceptance ofefficiency. It is hard to believe that managers would continue to attempt to manipulateinvestors beliefs if an efficient market immediately detected and penalized such behaviour.On the other hand, bad earnings management may hide behind poor disclosure. If the marketis not aware that reported earnings are being managed, it can hardly be concluded that themarket is inefficient. Rather, the question is whether the market will react once itCopyright 2009 Pearson Education Canada

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suspects or becomes aware of the earnings management. The markets negative reaction tothe frequency of non-recurring charges as an indicator of possible earnings management, asdocumented by Elliott and Hanna (1996) (see Section 5.5) suggests considerable efficiency,for example. Also, the markets post-Enron suspicion of GEs earnings management,discussed above, is also consistent with efficiency.The text concludes that at least some managers do not accept market efficiency. However, italso concludes that markets are sufficiently close to full efficiency that improved disclosurewill reduce bad earnings management.5.

To Summarize the Strategic Aspects of Accounting Policy Choice

I end my discussion of earnings management with two main points:

(i)

I emphasize the concept of strategic accounting policy choice, whereby

may include efficient contracting, such as avoiding excess earnings volatility forcompensation and debt covenant reasons, which may conflict with accounting policiesthat are most useful to investors. This greatly expands the role of financial reporting,since we now formally recognize two main roles of financial reporting reporting toinvestors and reporting on manager performance. Both roles matter since the qualityof manager effort and the well-working of managerial labour markets is as important tosociety as the quality of investor decisions and the well-working of securities markets.The conflict between these two roles, I hope, validates to the class the time spent onbasic game and agency-theoretic concepts of conflict in Chapter 9.(ii)

I emphasize that managers have a legitimate interest in accounting policy

choice, since their operating and financing policies, and even their livelihoods, are atstake. This view is in contrast to many discussions of standard-setting wheremanagement seems to be the bad guys, opposing every new standard that comesalong. The theory provides several legitimate reasons why managers will beconcerned about changes to GAAP.

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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS

1.

Some reasons why a firms management might both believe in securities marketefficiency and engage in earnings management are:

Income taxation. The firm may be able to postpone payment of taxes if it

can minimize its reported income, for example by managing accruals, orusing LIFO (if allowed by the tax authority).

Managerial bonus plan. As Healy documents, managers have incentives to

maximize their bonuses, consistent with the bonus plan hypothesis ofpositive accounting theory. Consequently, they may adopt accountingpolicies to increase reported net income, or to reduce reported net income ifit is below the bogey or above the cap of the bonus plan.

Covenants in lending agreements. Managers may adopt policies to increase

reported net income, or other financial statement variables, to avoidcovenant violation or even to avoid being too close to violation. Lendingagreements may also induce income-smoothing behaviour. A smoothsequence of reported net incomes will reduce the probability of covenantviolation.

A smooth earnings sequence may increase the willingness of lenders and

suppliers to grant short-term credit. This is particularly so if the firm hasimplicit contracts with these stakeholders.

Political visibility. By reducing its reported net income the firm may forestallgovernment intervention which might ensue if the public felt the firm wasearning excessive profits. Question 10 of Chapter 8 illustrates this point.

Earnings management can be a credible way to communicate the firms

inside information about its longer-term expected profitability to the market.

Taking a bath involves writing off assets against the current years operations and/orproviding currently for future costs. As a result, future years reported earnings arerelieved of amortization, and provisions for future costs can absorb items that wouldotherwise be charged against current earnings.Furthermore, if provisions for future costs are excessive, reversal of the excess willincrease current earnings.Consequently, future years reported earnings will be higher (or losses lower) thanthey would otherwise be, and the probability of the manager receiving a bonuscorrespondingly increases.

3.

Next years earnings will be reduced by $1,300 due to the iron law of accrualsreversal. With respect to credit losses, there is a $500 lower cushion to absorb creditlosses in the following year. Consequently, next years credit losses expense will be$500 higher, other things equal.With respect to warranty costs, a similar argument applies. The lower the accruedliability for these costs, the lower the cushion to absorb payments for warranty costs inthe following year. Consequently, next years warranty cost expense will be $800higher, other things equal.

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4.

a.

You would react negatively to the extent that the charge to record the liabilities

reduced net income for bonus purposes. However, the Compensation Committee maybase the bonus on net income before deducting the charge, particularly if it wasaccounted for as an extraordinary item. (See Question 13 of Chapter 10 re BCE Inc.on this point. See also the evidence of Gaver and Gaver (1998) in Section 10.6, whoreport that extraordinary gains tend to be included in the determination of cashbonuses but not extraordinary losses.)A counter argument is based on the evidence of Healy (1985). If your net incomebefore the charge is below the bogey or above the cap of your bonus plan, you mayprefer that the charge be included in net income for bonus purposes.b.

You would react negatively. A reason is that the increased volatility would

increase the chance that reported net income would fall below the bogey or above thecap of the bonus plan. If this happens, it would require you to either manipulateaccruals or forego your bonus.c.

You would react negatively because your expected bonus would be lowered,

with no compensating decrease in bonus volatility.

d.

You would react negatively to a reduction in your ability to choose from different

accounting policies, because your freedom to manipulate discretionary accruals, such

as choice of inventory costing method, for bonus, debt covenant or political reasonswould be reduced.Also, your ability to communicate inside information about long-term earning power tothe market would be reduced for the same reason. This could adversely affect cost ofcapital, hence future earnings.

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5.

The following points should be made:

Generally speaking, fair value accounting for financial instruments

eliminates the ability to manage earnings through gains trading, since theamounts and timing of the resulting unrealized gains and losses are nolonger under management control.

Some earnings management potential may exist under IAS 39 and SFAS115 by transferring financial assets between categories, such as fromheld-to-maturity to trading or available-for-sale. This triggers anunrealized gain or loss on the transferred items. However, a sale ortransfer out of the held-to-maturity category is inconsistent with an intentto hold securities in this category to maturity. Thus, these standardscontain provisions to severely limit such possibilities. For example, ifsuch a transfer is made, IAS 39 prevents use of the held-to-maturitycategory for two years. This eliminates the ability to manage earnings onfuture transfers of this nature.

However, under IAS 39 and SFAS 115, unrealized gains and losses onavailable-for-sale securities are excluded from net income. Then, theremay be a potential for earnings management by actual sale of financialinstruments, since any realized gains and losses on these instrumentswill then be transferred into net income.

Where market values for financial instruments are not available, someability to manage unrealized gains and losses remains, since fair valueswill then have to be estimated. Management may influence unrealizedand realized earnings by managing the fair value estimates.

We may conclude that while managing earnings for bonus purposes will be reducedunder fair value accounting for financial instruments, some ability to manage earningsremains.

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6.

a.

The various accruals for JSA Ltd. are as follows:

Add back tonet income- Depreciation and amortization.

Deduct fromnet income

$14

Mainly non-discretionary, since method

of amortization and useful lives fixedby policy. However, manager has somediscretion to change policy on occasion.- Reduction of liability for future income tax

Discretionary, since manager controls

May be driven by increased level of

business activity. However, managerhas considerable discretion over allowancefor doubtful accounts and some discretionover credit and collection policy.- Decrease in inventories.

18

May be driven by lower level of business

activity, but seems unlikely since accountsreceivable have increased. Manager hasconsiderable discretion over valuation ofobsolete, used or damaged items. Also,under lower of cost or market rule,manager has discretion over amountsof writedowns.- Increase in prepaid expenses.

Largely non-discretionary, although

manager may influence number andamounts of advances.- Decrease in current portion of long term debt.

Non-discretionary, since fixed by contract.

-

Increase in current portion of future income

tax liability.

Non-discretionary, since income tax

act specifies.$50

$31

31Net income-decreasing accruals

$19

Check:Net income

$(12)

Net income-decreasing accruals

19

Cash flow from operations

$7

Note: Students often deduct from net income a $1 accrual for the increase in deferreddevelopment costs on the balance sheet. This throws them out of balance. There isnot enough information on the income statement to know if deferred developmentcosts are being amortized. It appears not. The most likely explanation for the increase

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in this item is that it results from a non-operating transaction, such as cash paid out forsome capitalized development cost.b.

i)

Pick a specific account for which it is relatively easy to estimate the

discretionary component, such as net accounts receivable. Here, based on past

collection and bad debts history, it is relatively easy to determine what the balance ofthe allowance for doubtful accounts should be. The discretionary accrual is then thedifference between what the balance should be and the actual balance.ii)

Use the Jones model, which is a regression equation to estimate non-

discretionary accruals after allowing for the levels of business activity and capitalinvestment. Discretionary accruals are then taken as the difference between thisestimate and total accruals.c.

The manager may take a bath, by writing off investments in capital assets and

setting up provisions for future costs such as reorganization and layoffs. This willreduce reported net income this year, but the probability of high net income in futureyears is increased, since future amortization charges will be lower and future costscan be charged against the provisions rather than against net income. Furthermore, ifthe provisions turn out to be higher than actually needed, the excess amounts can bereversed into future years operations.Alternatively, the manager may income maximize, so as to increase net income abovethe bogey. However, this tactic is unlikely to be used unless pre-bonus earnings areonly slightly below the bogey.Obviously, the most suitable accruals are those with the greatest discretion, andrelative invisibility. These include maximization of prepaid expenses, and minimizationof the allowance for doubtful accounts and accrued liabilities. Changes in amortizationpolicy and useful life estimates of capital assets are possibilities. However, they arequite visible and could not be used very often.

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7.

a.

Reasons to resort to extreme earnings management tactics:

To meet analysts forecasts. As stated in the question, this was the apparentreason in BMS case.

Implicit contracts. To increase earnings so as to receive better terms from

IPO. The firm may have wanted to increase and/or smooth earnings so as toincrease proceeds from a planned IPO.

b.

From the standpoint of a single year, stuffing the channels seems effective.

This is because it is hard to detect.

Such behaviour may possibly be detected through full disclosure, such as sales byproduct, segment, or region. Then, careful analysis may reveal unusual sales patterns.However, the company has little motivation to provide full disclosure unless requiredby GAAP and/or insisted upon by the auditor.Wholesalers may object if too much inventory is forced upon them. Since wholesalersare not formally BMS employees, it may be more difficult to keep them fromcomplaining to regulators or the media. However, in BMS case, paying their carryingcharges may have been a device to avoid such complaints.Over a series of years, stuffing the channels is likely to be less effective, for thefollowing reasons:

Accruals reverse. Product stuffed into the channels this year will reducesales next year. Ever more stuffing is needed if the strategy is to bemaintained.

Physical limitations. There may be limits on wholesalers storage space.

device since it can be hard to detect. The firm has some flexibility about the

extent of disclosure of gains and losses from asset disposals (see discussion reunusual, non-recurring, and extraordinary items in Section 5.5.). Furthermore,overprovision for losses puts future earnings (i.e., cookies) in the bank (jar), and GAAPdoes not require separate disclosure of the effect on operating earnings when theseaccruals reverse.Full disclosure of unusual, non-recurring, and extraordinary items may tip off anefficient market as to the possibility of cookie jar accounting. This effect wasdocumented by Elliott and Hanna (1996)see Sections 5.5 and 11.6.1. While even anefficient market will not really know the actual extent of such accounting without fulldisclosure, suspicions may lead to SEC investigation. This seems to have happened toBMS.Effectiveness of cookie jar accounting can be increased if it is used responsibly toreveal managements estimate of persistent earning power (i.e., good earningsmanagement). It seems unlikely that BMS was using it in this manner, however.We conclude that while cookie jar accounting can be reasonably effective, and has thepotential to be good, its continuing and excessive misuse may lead to its discoveryand subsequent penalties.BMS appears to have been using cookie jar accounting to smooth reported earnings.

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8.

a.

In the short-run, capitalizing expenses to manage earnings is of moderate

effectiveness. On the one hand, the reduction in current reported expenses is

considerably greater than the increase in amortization, so that there is scope for aconsiderable increase in reported profits. Furthermore, capitalizing expenses does notreduce current operating cash flows (since they are included in the investing, not theoperating, section of the funds statement). As a result, techniques that attempt toidentify earnings management by estimating discretionary accruals, such as the Jonesmodel, will not work.On the other hand, effectiveness is reduced because capitalization of expenses iscontrary to GAAP. As a result, unless the capitalizations can be concealed from theauditor, they will have to be reversed or the firm will receive a qualified audit report.The ability to conceal becomes more difficult the larger the amounts capitalized.In the longer run, the scope for increasing reported profits and the lack of effect onoperating cash flows continues. However, as amounts capitalized continue toaccumulate, it becomes more likely that this earnings management will be discovered.We conclude that effectiveness is only moderate in the short run and declines overtime.b.

The importance of meeting earnings targets derives from securities market

efficiency and rational investor behaviour. A firms share price will incorporate themarkets expectations of future firm performance. Earnings targets, for example thoselaid down by management forecasts and/ or by analysts, are an important indicator offuture performance. If these targets are not met, investors expectations of future firmperformance will fall and share price will quickly fall with them. This is likely to be thecase even if earnings are just short of target, since the market will suspect that if thefirm could not manage earnings upwards by a small additional amount, its future mustbe bleak and/or management is unable to predict the firms future operations.As a result, managers compensations, including the value of share holdings, ESOs,and other share price-based compensation will fall. The managers reputation, tenure,and the firms cost of capital will all be negatively affected.To avoid these consequences, managers strive to meet earnings targets.Copyright 2009 Pearson Education Canada

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c.

Large public companies may discontinue earnings forecasts to avoid the

negative consequences of failing to meet them. Forecasts provide an incentive for themanager to exert effort to attain them. However, if it appears the forecast will not bemet in the normal course of business, the manager may attempt to meet them throughdysfunctional behaviour such as bad earnings management, excessive cost-cutting,and/or deferral of maintenance. In effect, meeting forecasts encourages short-runbehaviour at the expense of longer-term firm interests.

9.

a.

Restructuring charges are an effective earnings management device. They are

an unusual and non-recurring item, hence of low persistence. As a result, they may beignored by investors in evaluating operating earnings, and by compensationcommittees for bonus purposes.However, the reasonableness of the amount of the restructuring charge is difficult forinvestors and compensation committees to evaluate. Consequently, as Hanna (1999)argues, management may overstate the amount, thereby putting earnings in the bank.These future earnings increases are also difficult to detect, since they become buriedin lower amortization and/or used to absorb costs that would otherwise be charged tofuture earnings. Thus management can have it both wayslittle penalty when thecharge is reported, and reward for increased future operating earnings. In effect,Hannas argument is that restructuring charges are too effective an earningsmanagement device since they create temptations for opportunistic managerbehaviour.With respect to GE, it seems that restructuring charges are used in conjunction withother earnings management devices to manage current reported earnings. GEs goalseems to be to report steadily increasing earnings. This goal rules out reporting hugeincreases in earnings currently, such as earnings from large extraordinary gains, sinceit may be hard to top these earnings in future years. Then, restructuring charges servea role of reducing current reported earnings to a desired level. Given the variety ofother earnings management devices at its disposal, it seems unnecessary for GE tooverstate restructuring charges. If it did, it is unlikely that it could sustain the pattern ofsteadily increasing earnings it has reported. Overall, GEs use of restructuring chargesCopyright 2009 Pearson Education Canada

It seems unlikely that GEs share price always fully reflects all publicly available

information. Costs of fully analyzing all information, and idiosyncratic risk, contribute tolack of full market efficiency. In GEs case, costs of analysis are particularly high, sincethe firms complexity makes it difficult even for analysts to fully interpret GE. Also,investors who wish to eliminate idiosyncratic risk would find it difficult to find similarfirms to invest in. Thus, any anomalies and resultant mispricing of GE shares are likelyto persist.However, any mispricing will be reduced, if not eliminated, if GEs management usesearnings management responsibly to reveal its expected persistent earning power,since share prices are based to a considerable extent on expected future earnings. Ifmanagements inside information about expected earning power is accurate, GEsshare price should trade at a price similar to its price if the market had fully digested allpublicly available information.c.

The answer follows from part b. It seems that GE is using earnings

This stands in for the difficulty analysts and investors face in fully evaluating allavailable information themselves. As a result, GEs share price should reasonablyreflect its future performance. We conclude that, in this case, GEs earningsmanagement is good.Note: This is an excellent article for class discussion. I begin by discussing thevarious earnings management devices that the question refers to, each of which canbe discussed as to its effectiveness. The important point to bring out, however, is thatGE apparently uses these devices in concert, as part of a strategy to generate asmooth, growing earnings series.It is also worth reminding the class that the accrual basis of accounting involvessmoothing of annual or quarterly cash flows. Indeed, this is the reason the FASB givesin SFAC 1 for favouring accrual accounting over cash flow accounting as an indicatorof an enterprises present and continuing ability to generate favorable cash flows....Copyright 2009 Pearson Education Canada

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See Question 7 of Chapter 3. I then suggest that GEs use of earnings management isa multi-period version of the same argument.I also ask the class whether they would go along with GEs use of earningsmanagement if they were its auditor. Usually, the answer is yes, since nothing GEdoes seems inconsistent with GAAP. Then, I point out that, in effect, management candrive a truck through GAAP, and ask what prevents a firm from reporting just aboutany net income it wants. The answer is very importantaccruals reverse. This is whatputs discipline on the earnings management process, and is food for thought for anybudding accountant/auditor/manager. This point is illustrated with a vengeance inQuestion 10 re Sunbeam Corp.Instructors may wish to follow up on GE subsequent to the Enron collapse. GEsimpressive earnings sequence continuing to at least 2006 tends to validate its preEnron earnings management activities. That is, if GE had been excessively pumpingup its reported earnings pre-Enron, it could hardly have continued to report earningsincreases in subsequent yearsthe iron law would have caught up with it sooner orlater.The decline in investor confidence in financial reporting following Enron led to severeshare price declines for many firms for which there was even a faint suspicion ofreporting irregularities and lack of transparency. As a well-known practitioner ofearnings management, GE was no exception. GEs response is interesting. Oneresponse was to greatly increase its disclosure, including for its GE Capital subsidiary.See the discussion in point 3 of the Learning Objectives and Suggested TeachingApproaches above, including problem 21 of Chapter 12. Also, according to an article inThe Globe and Mail by Elizabeth Church (April 1, 2002, p. B6), GE expanded thenumber of pages in its 2001 annual report by 30%. See also, GE changing its reportsto provide more details, in The Globe and Mail, February 20, 2002, p. B11 (reprintedfrom The Wall Street Journal). The Globe also reported on GEs 1st quarter, 2002results (GE reports profit up, revenue flat, by Stephen Singer, April 12, 2002, p.B6).GEs reported net income for the quarter was $3.5 billion (before accounting changes),compared to $2.57 billion for the same quarter of 2001. However, its revenues werealmost the same as for the 1st quarter, 2001. Its share price fell by 9% on the day itCopyright 2009 Pearson Education Canada

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released its results. Obviously, the market is suspicious about how its quarterlyearnings increased when revenues were flat.Another GE response was to amend its manager compensation plan, to reduce theuse of ESOs. See Problem 10 of Chapter 10 for an account of restricted stock unitsawarded to its CEO in 2003, in place of ESOs. See also a reference to its policy of notrepricing ESOs in Problem 14.c of Chapter 10.10.

a.

Laing reports a $23.2 million dollar drop in prepaid expenses in 1997. The

offsetting debit in 1997 was, presumably, to expense (Dr. Expense $23.2, Cr. PrepaidExpense $23.2). If so, the drop in prepaid expenses has decreased 1997 net income,not increased it as Laing asserts.Laing notes that 1996 was a lost year anyway, so the company prepaid everything itcould. He seems to imply that prepaying everything served to decrease 1996 netincome, which, of course, is incorrect since prepaid expenses are assets. He thenstates that costs for 1997 were reduced markedly. In fact, 1997 costs would beincreased, as the 1996 prepaid expense accruals were used up in 1997.Note: An alternative interpretation of what Laing meant is that the company prepaideverything it could in 1996 but charged the prepayments to expense in 1996. Thiswould have the effect of decreasing 1996 earnings and increasing those of 1997, ashe asserts. But, if this is what Sunbeam did, the decline in prepaid expense from 1996to 1997 does not measure the amount by which earnings were affected.

Decrease in allowance for

doubtful accounts from $23.4

Manufacturing for stock in 1997,

evidenced by 40% increase ininventories

$10

Early buy and bill and hold

sales of $50

$8

$105.5Less total of Decrease columnNet discretionary accruals

___

$15

15$90.5

Total accruals can be determined as the difference between net income andoperating cash flow:$109.4 - (-$8.2) = $117.6We may conclude that $90.5 million of the total accruals of $117.6 million werediscretionary, income-increasing. It thus appears on the basis of Laings analysis thatSunbeams 1997 reported earnings were largely manufactured.c.

The article implies that the restructuring charges of $390 million were

excessive. This puts earnings in the bank, which can be drawn down in future yearsthrough reduced amortization and charging of operating costs to the restructuringreserves.d.

Sunbeams reported first quarter, 1998 earnings were a loss of $44.6 million,

compared with a profit of $6.9 million for the first quarter of 1997.Sales were reported as $244.5 million, a decrease of $9 million from the first quarter of1997. While a decline in actual sales may be at least partly responsible for the firstquarter loss, the reported sales would have been pulled down by the reversal of the

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$50 million of early buy sales accruals recorded in 1997. It appears that the efforts topump up first quarter sales (additional buy now, pay later sales, extending quarterby 3 days) fell short of overcoming the reversal of the sales prematurely recorded in1997.With respect to expenses, some of the expense reductions, such as amortization,noted for 1997 would continue in 1998. However, many others would reverse, such aswarranty expense, allowance for doubtful accounts, and manufacturing for stock(which would lower 1998 production, hence the amounts of absorbed overhead).In sum, the early recording of sales in 1997, together with the reversal of discretionary,income-increasing 1997 accruals, seems to have come home to roost in 1998,consistent with the iron law of accruals reversal.Note: Subsequent articles relating to Sunbeams accounting problems include:

S.E.C. Accuses Former Sunbeam Official of Fraud, The Wall Street

Sunbeams ex-CEO settles SEC probe, The Globe and Mail,

September 5, 2002, p. B6. The article reports that Mr. Dunlap will pay$500,000 (U.S.) to settle charges he used inappropriate accounting

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techniques that hid Sunbeams financial problems. Former CFO Russell

Kersh will pay $200,000. Both men were barred from ever serving asofficers or directors of any public company. Mr. Dunlap has also paid $15million and Mr. Kersh $250,000 to settle a class action lawsuit overmisrepresentation of Sunbeams results of operations.

Morgan Stanley duped financier Perelman in fraudulent deal, Financial

Times, April 7, 2005, page 16. The Laing article mentions Sunbeamsacquisition of Coleman Co., a maker of camping equipment. TheFinancial Times article reports that Ronald Perelman, a wealthy financierand chairman of cosmetics firm Revlon, is suing Morgan Stanley, a largeinvestment bank. Perelman had owned 82% of Coleman, and acceptedSunbeam shares as payment. The lawsuit claims that Morgan Stanleyhelped Sunbeam dupe Perelman about the value of Sunbeam shares,which collapsed in value when the earnings management described inthe Laing article was revealed.

11.

a.

Managers may want to smooth earnings for the following reasons:

They may feel that the market rewards share prices of firms thatreport steadily increasing earnings, consistent with the findings ofBarth, Elliott, and Finn (1999).

They may want to keep earnings for bonus purposes between thebogey and cap of their bonus plan.

They may want to reduce the probability of violation of debt

covenants.

They may want to convey inside information about persistent earning

power by smoothing reported earnings to an amount they feel can besustained.

They may smooth earnings because of implicit contracts, consistent

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may be able to secure better terms from suppliers and other

stakeholders with which it has a continuing relationship if it reportssteady earnings.b.

Costs of smoothing earnings by means of opportunistic discretionary accruals

derive primarily from negative investor reaction should the firms usage of suchdiscretionary accruals to manipulate earnings be discovered by the market. Investorsmay then lose confidence in the integrity and transparency of the firms reporting (i.e.,their perception of estimation risk increases), leading to a fall in its share price.Costs of smoothing earnings by means of derivatives include the commissions andother costs paid in order to acquire and sell the derivative instruments. Also, if the firmexcessively smooths its earnings in this manner, this reduces the managers incentiveto exert effort, since agency theory tells us that if he/she is to work hard, the managermust bear risk.Another potential cost is that hedging by derivatives reduces upside risk. The firm willnot benefit if underlying prices move opposite to the direction hedged. Smoothing byaccruals does not have this effect.Managers will trade off these 2 earnings management devices in order to minimizecosts. Smoothing by means of derivatives involves the use of real variables to manageearnings, with costs as given in the previous paragraphs. Smoothing by means ofaccruals also creates costs, deriving from increased investor estimation risk shouldopportunistic earnings management be revealed.Also, firms may differ in the amounts of discretionary accruals available. For example,firms that operate in a risky environment, or that are continually buying and sellingother companies and engaging in costly restructurings, have more accruals-basedearnings management potential than a stable firm in a stable industry where, forexample, there may be relatively few large unusual and non-recurring items withearnings management potential. Stable firms would find it less costly to smooth bymeans of derivatives.

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Other firms may already be heavy derivatives users and may be concerned thatfurther usage could turn into speculation, which could increase, rather than reduce,volatility of earnings . Alternatively, firms may be in a business for which a derivativesmarket does not exist or is very costly. For example, a firm with operations verysubject to the weather may find weather derivatives to be too costly. Other firms maywish to protect themselves against large credit losses but my find that creditderivatives are not available or are too costly. Such firms would find it less costly tosmooth earnings by means of discretionary accruals.c.

Bartons results are more consistent with the efficient contracting version of

positive accounting theory. If managers were not concerned about the costs to the firmof smoothing activity, they would not trade off the use of discretionary accruals andderivatives so as to find the lowest-cost way to smooth.12.

a.

Nortel appeared to be using a policy of big bath in 2001 and 2002, to put

earnings in the bank.

In 2003, the company appeared to be using a policy of income maximization, to enablebonuses to be paid.b.

One impact would be to increase manager effort directed towards increasing

sales and profitability. Presumably, this was the intention of the tying of bonuses to areturn to profitability. Nortels compensation committee may have felt that definingprofitability in terms of pro-forma income would contribute to this goal by eliminatingfrom the profit calculation expenses that were not informative about current sales andprofitability-oriented effort.However, another impact would be to encourage dysfunctional, short-run managerbehaviour, particularly if it seemed that increasing sales and profitability was moredifficult and lengthy than originally hoped. This behaviour apparently took the form ofreversing previous years excess accruals into current (pro-forma) earnings.Dysfunctional behaviour could also be encouraged by defining profitability in terms ofpro-forma income. Since there are no rules laid down to define items that can beexcluded from pro-forma income, management may have been tempted to omit lossitems that were informative about effort.Copyright 2009 Pearson Education Canada

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c.

Nortel went wrong because of poor disclosure. It credited the reversals of

excessive accruals into 2003 operating (and pro-forma) income without disclosing theirsource. This created the impression that the increased 2003 earnings were due tocurrent manager effort (hence persistent) rather than simply a restatement of pastover-provisions.Matters were made worse by payment of bonuses. These were intended to encouragecurrent effort but seem to have had the opposite effect of diverting effort intomisleading financial reporting.

13.

a.

The current financial report shows GN. Two points should be mentioned. First,

the persistence of the non-recurring item is low by definition. Thus, it is unlikely to havemuch effect on future earnings. This suggests future earnings will be high since thecurrent non-recurring item will likely reduce future amortization charges and/or providea cushion against which future charges that would otherwise be debited to futureearnings can be made.Second, it appears that CG manages its earnings so as to report a smooth andgrowing sequence over time. Thus, the role of the current non-recurring loss seems tobe to reduce reported earnings for the quarter to an amount management expects topersist. This means that the current increase in earnings will be maintained and likelyincreased.Note: Answers that argue BN on the grounds that the analysts consensus forecastwas only met, not exceeded, are not acceptable. Under the circumstances (increasedearnings, despite a large non-recurring loss) it seems hard to interpret currentearnings as BN.b.

By Bayes theorem, the posterior probability of the high state, based on GN in

Yes, your evaluation of the earnings report should now be BN. Managers know

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are not met. If the manager cannot find enough earnings management to raisereported earnings by 1 cent per share, the firms earnings outlook must be bleak.

14.

a.

The revenue deferral will decrease relevance, since there is now a greater

recognition lag for contract revenue. This reduces the ability of investors to revise stateprobabilities and predict future cash flows of the firm. However, reliability will increase, sincethere is now less chance of error or bias in revenue recognition.b.

Nortel appears to be following a pattern of big bath for 2005. The shareholder

litigation expense item creates a large loss for the year. Nortel may feel that this wouldbe a good time to defer revenue, since there is a large loss anyway, and, sinceaccruals reverse, deferral now will increase revenue to be recognized in futureperiods.c.

Abnormal return is the difference between expected and actual share return for

the day. From the market model, the expected return for Nortel for t = March 10/06was:Rjt = j + j RMt, where j = Rf(1 j)= .0001(1 1.96) + 1.96 .0058= -.0001 + .0114= .0113The actual return on Nortel shares for this day was - .0305. Abnormal return was thus(-.0305 .0113) = - .0418, or - 4.18%.The abnormal share return likely arose because of the revenue deferral, since themarket would have been aware of the shareholder litigation and would haveincorporated the expected settlement amount into Nortels share price prior to MarchCopyright 2009 Pearson Education Canada

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10. The news of the deferral would cause investors to lose confidence in Nortelsaccounting, increasing estimation risk.An opposite answer can also be supported, for either of 2 reasons:

If the amount of the settlement exceeded the markets expectation, the news ofthe settlement amount could have caused the negative abnormal return.

If markets are not fully efficient, the market may not have incorporated anexpected settlement amount into Nortels share price prior to the news of March10.

resulting from accounting restatements will not occur frequently over several years.Also, such lawsuits do not typify the normal business activities of Nortel. Inaddition, the amount or timing of the expense does not seem to depend ondecisions or determination by managers or owners. Thus, the 3 requirements foran extraordinary item are met.Nortel may have intentionally overestimated its litigation settlement costs chargedto current operations, in order to put earnings in the bank. If so, this is consistentwith the argument of Hanna (1999). To the extent actual litigation costs are lessthan $2.474 billion, the difference can be transferred back to earnings fromcontinuing operations at some future date.

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15.

a.

Revenue recognition is an effective earnings management device because

recognition criteria under GAAP are vague and general. A company can speed up, orslow down, revenue recognition but disguise the change through vague wording of itsrevenue recognition accounting policy disclosure. Also, as in the case of Coca-Cola,revenue recognition can be speeded up by stuffing the channels to unconsolidatedsubsidiaries or customers, without any formal change in revenue recognition policy.Stuffing the channels can be difficult for investors, or even auditors, to detect.A superior answer will point out that revenue recognition is an accruals-based earningsmanagement policy, whereas, stuffing the channels involves real variables.A disadvantage of revenue recognition as an earnings management device is thataccruals reverse. Consequently, it is difficult to maintain increased reported revenueover time. Also, stuffing the channels becomes quite costly if it is necessary tocompensate the subsidiary or customer for carrying costs, as Coca-Cola did.Possible reasons why Coca-Cola managed its reported earnings upwards:

Contractual. To smooth or otherwise manage executive compensation where

this is based on reported earnings, and to reduce the probability of violation ofdebt covenants.

To maintain or increase managements reputation.

Income taxes. To reduce or otherwise manage income taxes payable.

Changes in CEO. CEOs may manage earnings to reduce the probability of

being fired, to reduce the probability of a successful takeover bid, or becausethey are approaching retirement.

IPOs. Firms may manage earnings upwards prior to a stock offering so as to

increase the issue price.

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Implicit contracts. To maintain good relations and credit terms from suppliers.

Communicate inside information to investors, providing the upward

management is not to an amount higher than can be sustained.

b.

Since gallons shipped in one quarter correspondingly reduce amounts shipped

in future quarters, an increase in EPS this quarter will create a corresponding

decrease in EPS next quarter. Consequently, even more gallonage must be pushed ineach successive quarter to maintain an EPS increase.c.

The reason appears to be to avoid a reduction of future core earnings when

bottlers inventories cannot be further increased and reported sales fall off. Theinventory reduction program could be accounted for as an unusual and non-recurringcomponent of operating income. This would have the appearance of low persistence,reducing negative investor reaction to the inventory reduction and to lower sales andearnings in 2000.16.

a.

Reasons why Deutsche Bank shares rose on October 3:

Reduction of uncertainty. Given the market meltdown of asset-backed

securities, the market had little idea of their fair value, hence little idea of thelosses faced by firms holding these securities. The EUR 2.2 billion writedowngave investors at least a ballpark figure of Deutsche Banks losses. The result isto lower estimation risk and/or lower Deutsche Banks beta (since DeutscheBanks loss provides some information about losses of other banksseeSection 4.5), both of which raise stock price.

The amount of the writedown may have been less than the market expected.

Cleaning house. The market may have felt that the writedown signals thatDeutsche Bank has put its losses behind it and will now turn its full attention toincreased future profitability.

Optimistic earnings forecast. The market may have felt that the CEOs reaffirmation of Deutsche Banks 2008 profit forecast indicated that he felt that the

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companys asset-backed securities losses were now behind it and that he feltsecurities markets will return to normal functioning.b.

Reasons why the bank may have wanted to take a bath:

Investors feared the worst. Consequently they would not penalize DeutscheBank unduly if the writedown was inflated.

Cookie Jar. Since the company reiterated its 2008 profit forecast, it would beanxious to avoid the consequences of not meeting it. Putting earnings in thebank by means of a cookie jar increases the likelihood that it will meet itsforecast.

c.

Reasons why the bank may want to understate its writedown:

Investor unease. Investors were concerned about the consequences for theeconomy of major losses by financial institutions. If investor concerns led torecession, this would reduce future bank profits. High reported writedownswould increase investor concerns.

Regulatory concerns. As a financial institution, Deutsche Bank may have been

If the reclassification becomes public knowledge, this will adversely affect

managements reputation and market value, and could lead to legal liabilitiesand penalties for the firm and its managers.

Once reclassified, the securities could not be sold until maturity. Situationscould arise such that it would be desirable to sell prior to maturity, but, if sold,the consequences under IAS 39 would be that use of the held-to-maturityclassification is denied for all securities for 2 years.

Ceiling test. Reclassification would be unlikely to avoid writedowns in any case,

since held-to-maturity securities are subject to a ceiling test.

Additional Problems11A-1. This problem is based on the paper by Elliott, Hanna, and Shaw (EHS), TheEvaluation by the Financial Markets of Changes in Bank Loan Loss Reserve Levels,The Accounting Review (October, 1991), pp. 847-861. While the main researchinterest of this article is information transfer (the impact of a firms financial statementson the share prices of other firms)a topic not covered in this book, the evidence in thepaper also provides an interesting and persuasive illustration of how earningsmanagement (in this case, the establishment of loan loss reserves) can reveal insideinformation.During 1987, many United States banks faced severe problems with respect to loansto lesser developed countries (LDCs). For example, on February 20, 1987, Brazildeclared a moratorium on interest payments on $67 billion of its debt. This led toproblems of how to account for the LDC loans by the banks that were affected.On May 19, 1987 (4.45 pm), Citicorp (a money-center bank and, at the time, thelargest U.S. bank) announced a $3 billion increase in its loan loss reserve for LDCloans. This amount equalled 25% of the book value of its LDC loans. In the 2 daysfollowing the announcement, Citicorps share price rose by 10.1%, after falling by3.1% on the day of the 4.45 pm announcement.Copyright 2009 Pearson Education Canada

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EHS also examined the share price behaviour of 45 other U.S. banks with foreignloans in excess of $100,000 and which announced increases in their loan lossprovisions during 1987. Of these banks, 11 (excluding Citicorp) were money-centerbanks (with major LDC exposure) and 34 other, regional banks (with lower LDCexposure). For a 3-day window surrounding the May 19, 1987 Citicorp announcement,EHS report the following abnormal returns:11 money-center banks:34 other banks

1.14%-.054%

On December 14, 1987 (4.15 pm), the Bank of Boston (not a money-center bank)announced a $200 million increase in its LDC loan loss reserve, classified $470 millionof LDC loans as non-accrual of interest status, and wrote off $200 million of LDCloans. In the 3-day window centred on 15 December, 1987, its share price rose by9.9%. Banks were required to maintain a capital adequacy ratio (see note) of at least5% for regulatory purposes. The Bank of Bostons capital adequacy ratio remainedstrong (8%) after the writeoff.Note: The capital adequacy ratio is calculated as the ratio of shareholders equity plusloan loss reserves to total assets. Thus, a provision for loan losses does not affect theratio, while a writeoff of loans does.For a 3-day window centred around 15 December, 1987, EHS report the followingabnormal returns:12 money-center banks

-7.26%

33 other banks

- 1.14%

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Requireda.

Why did Citicorps share price fall by 3.1% on May 19, 1987 and rebound by

10% over the next two days?

b.

Why did the abnormal 3-day return for 11 money-center banks exceed the

return for the 34 other banks for the same period?

c.

Why did the Bank of Bostons share price rise by 9.9% over a 3-day window

surrounding December 15, 1987?

d.

Why was the average abnormal return of 12 money-center banks significantly

lower (-7.26%) than the abnormal return of 33 other banks (-1.14%) over the 3-daywindow surrounding December 15, 1987?

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Less: Cost of shares purchased

What is the amount of net accruals included in ACR Ltd.s year 2008 netincome?

b.

Use the information in the income statement and balance sheets of ACR Ltd. tocalculate the various individual accruals and reconcile to the net total in part a.

c.

Upon comparing operating cash flow and net income, we see that the accrualshave substantially lowered the reported income for the year. Give reasons whymanagement may want to manage income downwards in this manner.

11A-3.

A way to manage earnings is to manipulate the point in the operating cycle at

which revenue is regarded as earned. An article entitled Bausch & Lomb Posts 4thQuarter Loss, Says SEC Has Begun Accounting Probe appeared in The Wall StreetJournal on January 26, 1995.The article reports on questions raised by the SEC about Bausch & Lomb Inc.spremature recording of revenue from products shipped to distributors in 1993. Bausch& Lomb oversupplied distributors with contact lenses and sunglasses at the end of1993 through an aggressive marketing plan, and was forced to buy back a largeportion of the inventory [in 1994] when consumer demand didnt meet expectations.The oversupply amounted to around $10 million, which Bausch & Lomb claimed wasnot material.In addition, the article points out that in the fourth quarter of 1994 Bausch & Lomb hadincurred $20 million in one-time expenses, which included expenses from previouslyannounced staff cuts of about 2,000. Also, in the fourth quarter Bausch & Lomb tooka $75 million charge in its oral-care division in order to reduce unamortized goodwill

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that it recorded when Bausch & Lomb bought the business in 1988. Many analystsare saying that Bausch & Lomb are looking to sell the oral-care division, and thisreduction of unamortized goodwill will make the division look better.Requireda.

What earnings management policy did Bausch & Lomb appear to be followingin 1993?

b.

Evaluate revenue recognition policy as an earnings management device.

c.

The article refers to a $20 million writeoff in 1994 relating to staff cuts, andanother $75 million writeoff in Bausch & Lombs oral-care division. Whatearnings management strategy does the firm appear to have followed in 1994?Why?

11A-4. Note: The 5th edition of this text has removed discussion of push-down accounting.Earnings management extends into the realm of new share offerings (IPOs), since theprospectus for a new offering includes current and recent financial statements. Anarticle entitled RJR Nabiscos Use of Accounting Technique Dealing with Goodwill IsGetting a Hard Look, which appeared in The Wall Street Journal on April 8, 1993,describes some earnings management considerations surrounding a $1.5 billion newshare offering of Nabisco, a food subsidiary of RJR Nabisco Holdings.According to the article, the parent, RJR Nabisco Holdings, has substantial goodwill onits books arising from its acquisition of Nabisco, which is being amortized at a rate of$607 million annually (at the time, both the CICA Handbook, and, in the United States,APB 17 required that goodwill from acquisitions be amortized over a period of up to 40years). However, this goodwill amortization appears only on the books of the parentnot on those of Nabisco.Copyright 2009 Pearson Education Canada

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According to the article, What RJR is doing is presenting Nabiscos annual earningswithout the burden of $206 million of 1992 goodwill, leaving this earnings-depressingitem with the parent company instead. This resulted in Nabisco increasing its 1992after-tax profit from $179 million to $345 million or from 48 cents a share to 93 cents ashare.The article goes on to state Nabisco executives indicated the food company couldgenerate 1993 earnings of as much as $1.30 a share. That earnings level might justifythe proposed selling price of $17 to $19 a share for the new Nabisco shares, analystssay.The article questions whether RJR is managing the reported net income of its Nabiscosubsidiary by not pushing down goodwill to Nabisco.Requireda.

What pattern of earnings management is RJR following? Why?

b.

Without considering any strategic issues surrounding the pricing of the newshares, do you think that goodwill should be pushed down to the subsidiarycompany?

c.

Do you think the strategy of not pushing down the goodwill will be successful inraising the issue price of the new shares? Explain why or why not.

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Suggested Solutions to Additional Problems

11A-1 a.

The 3.1% fall could have been due to a fall in the stock market index (i.e.,

economy-wide risk) on that day. (EHS investigated this possibility, and concluded thatthe fall was not the outcome of general macroeconomic events.)The fall could have been due to investors anticipating the announcement and fearingthe worst. If so, the subsequent rise could have been because the actual loan lossprovision turned out to be less than the market had expected. However, this does notseem to explain why the subsequent share price increase was so highmuch greaterthan the 3.1% drop.The most likely reason for the initial fall is that the announcement was made quite latein the day and even rational investors did not have time to analyze the reasons for theloan loss reserve announcement. They then sold quickly to protect themselves in casethe announcement turned out to be bad news. Over the next 2 days, however, itbecame apparent that the loan loss provision was a signal that Citicorp had a strategyto deal with its LDC loan problems. Consequently, the banks share price reboundedby more than the initial decline.b.

The most likely reason follows from part a, namely that Citibanks

announcement was taken by the market to indicate that all exposed banks weretaking steps to deal with the problem. That is, the good news from Citibankcarried over. However, the less exposed a bank was, the less it would be affectedby the good news--it had less to lose in LDC loans in the first place, so informationsuggesting that it was taking steps to deal with the problem would have a smallereffect on its share price. Thus the most-exposed bank (Citibank) enjoyed thegreatest share price increase (10.1% - 3.1% = 7%), followed by the 11 otherexposed money-center banks (1.14%) and the 34 least-exposed other banks (0.54%). The reason the return is negative for these latter banks is likely becausethe good news was not good enough to outweigh the losses from writeoffs per se.

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c.

The same reasons as for part a apply here. In addition, the Bank of

Bostons capital adequacy ratio was still well above the regulatory minimum, evenafter its $200 million writeoff. This seems to have been interpreted by the marketas an indication of the banks financial strength.d.

The answer seems to lie in the fact that the Bank of Boston, in addition to

increasing its loan loss provision, actually wrote off $200 million of LDC debt, therebytaking a hit to its capital adequacy ratio. The market apparently interpreted this as anindication that actual writeoffs were generally needed, but that other banks werereluctant to do this, creating fears that these other banks were concerned about theirown capital adequacy ratios, or they would have recorded writeoffs too. This argumentis consistent with the negative returns for all sample banks around December 15. It isalso consistent with the much larger negative abnormal returns for the money-centerbanks, which were much more exposed.

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11A2 . a.

Net accruals are the difference between operating cash flows and reported net

income. Here, net accruals for 2005 are $2,386 - 547 = $1,839.b.

The individual 2008 accruals of ACR Ltd. can be calculated and reconciled as

Net income as per income statement

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Reasons why management may want to manage income downwards by means

Political cost hypothesis of positive accounting theory. If ACR is very large, it

is very much in the public eye. It may fear political repercussions if it reportsearnings that are perceived as too high.

Bonus plan hypothesis. If it appears that ACRs earnings for bonus purposeswill be above the cap of the bonus plan, management may wish to lowerreported earnings. Otherwise, bonus will be permanently lost on above-capearnings.

Taxation. If firms in the United States use the LIFO inventory method forincome tax purposes, they must also use LIFO in their financial statements.On a rising market, LIFO reports a lower net income than other methods,such as FIFO. The firm then reports a lower net income in order to savetaxes. ACR does not indicate which inventory method it uses, however.

Taking a bath. The firm may want to increase the probability of high futureearnings by writing assets down currently and/or providing for future costs,such as for downsizing or reorganization. This motivation may be presentwhen a new management takes over, or when earnings are below the bogeyof the bonus plan. In the case of ACR, however, no unusual, non-recurringor extraordinary items appear on its income statement. Unless these areburied in larger totals, it seems this motivation does not apply to ACR in2008.

To communicate inside information to investors. If current years operations

have led to higher earnings than ACRs management thinks will persist, itmay wish to manage reported earnings downwards so as to credibly informinvestors of its best estimate of sustainable earnings.

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11A-3 a.

Bausch & Lomb appears to have followed a policy of income maximization in

1993.b.

Bausch & Lomb appears to have used revenue recognition policy as a device to

manage annual (1993) earnings. Such a policy is reasonably effective, at least in theshort-run, since revenue recognition criteria under GAAP are vague. This gives thefirm some room to manoeuvre in terms of timing of when it regards revenue asearned. In particular, current earnings can be increased by recogizing revenue onexcess shipments to distributors.In the longer run, however, a disadvantage of Bausch & Lombs early revenuerecognition policy is that it involved physical shipment of product to distributors. Theremay be limits to distributors storage capacity and ability to carry the additionalinventory, rendering the policy potentially quite costly. Indeed, it was this aspect ofBausch & Lombs 1993 policy that seemed to come back to haunt it in 1994, namely,the need for buybacks.Another longer run disadvantage of early revenue recognition is that accruals reverse.Thus, higher revenue recognized in 1993 means lower revenue in 1994. Then, evenmore shipments to distributors are needed in subsequent years if the policy is to bemaintained.We conclude that revenue recognition policy is reasonably effective in the short runbut its effectiveness decreases over the longer term.c.

Bausch & Lomb appears to be taking a bath in 1994. Presumably, this is to

increase earnings in subsequent years by clearing the decks, possibly to make itsoral-care division appear more attractive for a sale, or to bank earnings so as toincrease the probability of substantial earnings increases in future years.d.

Arguments that Bausch & Lombs management does not accept securities

market efficiency depend on the extent to which its earnings management strategiesare visible to investors. If these strategies are visible, there would be little point intrying to fool an efficient market. Consequently, visible earnings managementstrategies suggest management does not accept efficiency.Copyright 2009 Pearson Education Canada

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At least some of the firms earnings management strategies are visible. These includethe staff cuts and the $75 million charge in its oral care division.Visibility of other strategies, such as stuffing the channels in 1993 is less clear. Tothe extent that Bausch & Lomb felt the market would not find this strategy out, it isconsistent with acceptance of efficiency. That is, management could both acceptefficiency and feel that it could fool the market through lack of disclosure. However, itis also consistent with not accepting efficiency. Management may feel that even ifstuffing the channels was visible, the market would still react favourably to higherreported 1993 earnings.Additional arguments can be made based on contracting theory. The bath strategymay be for bonus purposes, consistent with Healys findings for earnings below thebogey. Management may both accept securities market efficiency and manageearnings for contractual reasons.Bausch & Lomb management may feel that with these 1994 writeoffs behind them, thefirms persistent earning power will be revealed, consistent with a desire to conveyinside information to an efficient market.Yet another possibility may be that management is signalling to the efficient marketthat it has its problems in hand and has a well-worked-out strategy to deal with them.This argument is consistent with the findings of Liu, Ryan, and Whalen (1997) withrespect to banks (see Section 11.5.2).

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11A-4. a.

RJR is following an income maximization policy with respect to Nabisco. A

possible reason is that RJR is planning a new Nabisco share offering. It seems tobelieve that higher reported earnings will enhance the offering price. Friedlan (1994)found evidence that firms use earnings management to increase reported net incomeprior to an IPO (Section 11.4.3).b.

According to the information approach, it should not matter whether goodwill is

pushed down as long as the amount is disclosed, since the efficient securities marketwill put the same values on shares of parent and subsidiary regardless. Certainly, theamounts involved here have been disclosed, since they are reported in the article.According to the measurement approach, goodwill should be pushed down since thisresults in more relevant values on the books of the subsidiary. Furthermore, the valueof goodwill should be reliably determined since it resulted from an arms-lengthacquisition transaction.Note: While it predates SFAS 141 and 142 and Sections 3062 and 1581 of the CICAHandbook, effective July, 2001, this question can also be discussed in relation tothese standards. They eliminate amortization of purchased goodwill (see discussion inSection 7.4.2). Then, pushing down goodwill to Nabisco is of less immediate concernto RJR management since, even if it was pushed down, there would be no goodwillamortization and resulting lower reported earnings, on Nabiscos books. However,purchased goodwill is subject to the ceiling test under the above new standards. Ifgoodwill on Nabiscos books should hit the ceiling, a writedown may be required.Then, Nabiscos reported earnings would be reduced if the goodwill had been pusheddown. Consequently, RJR management may still wish to avoid this possibility, by notpushing down.Of course, if Nabiscos goodwill should hit the ceiling, it would have to be written downon the parents (RJR Nabisco Holdings) consolidated financial statements, whether ornot it was pushed down.

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c.

The answer depends on the extent of securities market efficiency. Given full

efficiency, and full disclosure, the strategy should not affect the issue price. If marketsare less than fully efficient, the strategy may have an impact. The article seems toimply less than full efficiency, for example, by implying that share prices are set bymechanical application of earnings per share ratios. Also, theory and evidence frombehavioural finance (Section 6.2) suggests that investors may not be as adept atfiguring out complex transactions as efficient securities market theory implies. If so,pushing down the goodwill may help investors evaluate the real value of the shares ofNabisco.